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Pensions Cause Much Of The Pain As UK Moves To Raise Top Tax Rate

Alison Steed 9 June 2009

Pensions Cause Much Of The Pain As UK Moves To Raise Top Tax Rate

The UK government jolted the UK wealth management industry earlier this year with a proposed higher-rate income tax band but changes to pensions will add to the pain.

The proposed new income tax rate in the UK of 50 per cent has made many headlines in the wealth management industry, but the reduction in the tax benefits for pension contributions deserves more scrutiny as this will bite particularly hard.

The pension changes, announced in the UK budget in April, form part of a triple whammy: an increase in tax on those earning more than £150,000 ($241,986); the removal of the personal allowance for those earning above £100,000 - both from April next year - and the tapering of pension tax relief for those earning between £150,000 to £180,000 to just 20 per cent from 2011.

As a whole, the measures will add an extra £7 billion a year to the tax coffers by 2012/13 – around 5 per cent of the current total income tax take, according to figures from accountants Grant Thornton. Yet the government claims just 2 per cent of the population earn more than £100,000, around 1.2 million people.

Francesca Lagerberg, head of Tax at Grant Thornton said: "Coupled with national insurance contribution rises scheduled for 2011, an individual could face marginal tax rates as high as 61.5 per cent on earnings between £100,000 and £112,950.”

Alistair Darling, the UK’s finance minister, has justified such changes by saying these were “necessary to build our recovery and secure our country’s economic future”.

Critics of higher tax rates on the rich, such as the Institute for Fiscal Studies or the Adam Smith Institute, argue that raising tax rates beyond a certain point tends to reduce, rather than increase revenues in the long run because they blunt incentives and encourage wealthy people to move abroad.

Breaking the link between income tax and pensions tax relief is “setting a dangerous precedent”, said Tom McPhail, head of pensions research at independent financial advisor Hargreaves Lansdown.

“The government seems to assume that anyone who earns over £150,000 can be lumped into the same boat as Sir Fred Goodwin but that doesn’t make it alright to deliberately undermine their pension provision,” he said, referring to the former chief executive of Royal Bank of Scotland, who retired with a controversially big pension pot.

To determine whether your income exceeds £150,000, Mr McPhail said HM Revenue & Customs would consider the total income for the tax year before any personal deductions such as tax allowances, but less any deductions for relief, such as trading losses, pension contributions up to £20,000, and gift aid deductions.

He added: “But in calculating total ‘relevant’ income, any amount of employment income foregone by salary sacrifice in return for pension contributions or additional pension benefits if the agreement took place on or after April 22, 2009, must be added back. In deciding if the special annual allowance charge applies for a tax year, the relevant income for that tax year and for the two previous years is taken into account.”

“For example, if the individual’s relevant income was less than £150,000 in 2009/10, they could still be subject to the special annual allowance charge for that year if their relevant income was £150,000 or more in 2007/08 and/or 2008/09,” he continued.

“In 2010/11 similarly, if the relevant income is less than £150,000, the special annual allowance charge will still apply if the individual’s relevant income was £150,000 or more in 2008/09 and/or 2009/10,” Mr McPhail said.

So, no salary sacrifice measures will wash, but what can you do before the measures come into force?

Mr McPhail said: “For the next two years it makes sense for high earners to maximise their pension contributions by investing as much they can, being the higher of £20,000 and their normal pattern of contributions. Thereafter individuals will have to take a view on whether the tax relief rate on offer to them, between 20 per cent and 40 per cent, will be sufficiently attractive to merit making pension contributions as opposed to other forms of saving and investing.

“There may be problems with the HMRC definition of ‘regular contributions’ in determining what is acceptable for the next two years. Many of the self employed as well as high earners are more likely to be making annual lump sum investments, rather than monthly or quarterly payments. This is an issue which we will be taking up with HMRC,” Mr McPhail said.

Patrick Stevens, tax partner for Ernst & Young, said these changes would have a “significant impact” on the pensions industry, and could boost the high-end housing market as a by-product of the changes when people look for other homes for their income.

He said: “Most people earning over £180,000 now will probably be paying tax at 40 per cent or 50 per cent in retirement on their various pensions and savings. This means that on average, the money coming out of the pension scheme will in the future be taxed at 30 per cent or 37.5 per cent.

"So many higher earners will be looking for alternative homes for their savings for retirement. Individual Savings Accounts (ISAs) will obviously be fully used, but they probably already are. There will perhaps be a significant boost to the market for homes costing over say £1 million as this becomes a better place to save money," he said.

Andy Bell, chief actuary of A J Bell, one of the UK's largest SIPP providers, said there is likely to be a wider impact on pension saving too, as business leaders could easily lose faith with the system, and that attitude could easily be passed on to employees.

In judging the impact of higher-rate tax changes, then, the issue of pensions cannot be over-stated.

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